The pick-up in capacity utilisation is dodgy

India’s investment rate has been declining steadily from the 2008 peak of 39% of GDP

The uptick in RBI’s capacity utilisation indicator to 75.2 per cent in the fourth quarter of fiscal 2018 is seen by many analysts and investors as an indicator of an impending turnaround in India’s private capex cycle.

But according to us, a reason to be sceptical about a possible structural turnaround in private capex is that such hopes have emerged thrice in the past decade. First, during 2010-11, i.e., soon after the stimulus-led recovery post the global financial crisis. Second, when Narendra Modi was elected to power in 2014. Lastly, expectations have been built up over the past 6-8 months about a decisive turnaround in private capex.

But across these episodes, India’s investment rate (29 per cent of GDP in FY18) has been declining from its 2008 peak (39 per cent of GDP).

So does the RBI’s utilisation index provide an accurate indication of traction in private capex? Our short answer is: no.

The Q4FY18 reading of 75.2 per cent capacity utilisation is indeed the highest in the past two years.

Structural decline

But similar levels have been witnessed several times in the past three years: 74.6 per cent in Q4FY17, 75.5 per cent in Q4FY 2016 and 75 per cent in Q4FY14. In fact, it is a seasonal phenomenon, and on a seasonally adjusted basis, it declined in the Jan-March 2018 quarter.

The contrast is starker when one sees this indicator over a longer term. The most important inference is that there has been a structural decline in average capacity utilisation in the Indian manufacturing sector since 2014, which is alarming.

The average during Q1FY 2014-Q4FY 2018 is much lower at 73 per cent and substantially weaker than the pre-2014 average of 77.3 per cent.

Other important indicators from the RBI’s capacity utilisation data suggest improvement in the order book of Indian manufacturers. But the average inventory level of Indian manufacturing companies is also quite low. The recent recovery in the order backlog is more attributable to recovery from the post-demonetisation contraction of 56 per cent from the level seen prior to demonetisation.

Similarly,the recovery in average sales per company during FY 2018 is only a partial recovery from the post-demonetisation contraction. The average inventory level (finished goods, raw material and work in progress) as a percentage of sales, remains low even after the recovery post the demonetisation disturbance. At 44 per cent, it is much lower than the 51.5 per cent during FY09-Q2FY17.

So while the capacity utilisation as per RBI data has improved to 75.2 per cent, the trends in sales and inventory levels indicate that companies are still less confident about a meaningful recovery in sales growth compared with the period prior to demonetisation.

Our analysis of the capital goods index (within IIP (Index of Industrial Production) reveals that strong growth recovery in it during 2HFY18 has emanated from much distorted estimates of underlying deflators (estimated at -23.4 per cent in 2HFY18), which is at odds with any inflation indicator.

CMIE (Centre For Monitoring Indian Economy) data on investment projects suggest that investment activities remained slack even in Q1FY19.

Premature exuberance

Overall, the exuberance about a decisive revival in private capex appears premature.

Fiscal reflation ahead of the elections, including spending on railways and roads, are near-term positives for the investment cycle. But that is unlikely to be big enough to move the needle much — at best, it may help prevent further decline.

Sustainability of the recent traction in economic growth will depend on resuscitation of a sustainable private investment cycle, which has remained muted till now. It will also depend on a whole host of factors, such as corporate profitability, capacity utilisation, leveraging capability, bank lending capability, level of risk-free rate and revival in domestic savings.

The corporate deleveraging process is underway, but with banks’ credit-deposit ratio rising back to 76 per cent(little lower than its earlier peak of 78 per cent in 2012) after a transient decline to 68 per cent post-demonetisation, the ability of the banking sector to fund fresh investments will need to be strengthened materially.

Also, the risk-free rate has been rising quicker than the improvement seen in profitability of Indian corporates.

Corporate results for Q1FY19 thus far show that while sales growth has been robust, aggregate profit has grown at a modest pace of 5-6%, as companies face margin pressure from the rising cost of raw materials. This is much lower than the consensus expectation of 20 per cent profit growth. Clearly, the return ratios of India Inc are still quite feeble.

Productivity gains from GST reforms and the much-touted demonetisation reforms are still not visible.

The writer is Head of Research, Economist and Strategist, Emkay Global Financial Services.

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